On December 23, 2010, the Bankruptcy Appellate Panel of the 6th Circuit, upheld the Eastern District of Kentucky’s Bankruptcy Court’s order that post petition rents, revenues or other funds derived from leased real property is property of the estate under 11 U.S.C. §541 and can be used as cash collateral under 11 U.S.C. §363. However, post petition rents can be used as cash collateral only if the debtor can provide adequate protection for the use of those rents through an existing equity cushion in the property. The BAP ruled that the previously unpublished table opinion in Stearns Bldg. v. WHBCF Real Estate, 165 F.3d 28 (6th Cir. 1998), remained controlling.

A Kentucky limited liability company owned and operated a commercial real estate shopping center development. A lender entered into a construction financing agreement with the funds used to purchase approximately $34 million taxable industrial build revenue bonds. The bonds were to be repaid through lease payments made by the property owner to the city under a ground lease. The property owner’s obligation for financing was secured by an open end mortgage security agreement.

The entire source of the owner’s revenues was space subleased to tenants who paid rent. An assignment of rents and subleases was executed in favor of the lender. Under the assignment, the owner transferred all rents and profits from the property to the lender subject to a license back to the owner to collect and use the rents as long as the owner was not in default to the lender. The owner’s limited revocable license to collect and use rents was terminable automatically, without notice, upon an event of default.

The loan financing obligations matured, the owner failed to pay, and a default occurred.

The owner filed Chapter 11 bankruptcy in the Eastern District of Kentucky and contemporously filed an expedited motion for interim use of cash collateral seeking to use $260,000 as cash collateral to pay professional fees. The lender objected, arguing that rents were not the property of the estate. The Bankruptcy Court held the rents were the property of the bankruptcy estate but abated the use of rents for professional fees at that time. The lender filed a second objection on the basis that it was not adequately protected because no equity existed in the property. Based on testimony that future rents would exceed the cash needed to pay the lender’s debt in full, the Bankruptcy Court ruled the lender was adequately protected.

On appeal, the BAP for the 6th Circuit affirmed the ruling that rents were property of the estate in spite of the “absolute assignment” language in the agreement. Both sides agreed that Kentucky law applied and that the assignment of rents was a contract to be given the effect the parties intended. In support of the lender’s rent ownership claim, the assignment clearly stated “assignor hereby grants, transfers, sets over, and assigns to assignee, all of the right, title and interest of the assignor in and to: (a) all of the rents, revenues, issues, profits … arising from the [project].” The owner, however, relied on the language in the assignment stating that the assignment is a “grant of security interest” “given to secure” payment to the lender.

The BAP noted three “characteristics” of the assignment intending a security interest: (1) the owner retained the right to collect rents as long as no default; (2) when a default occurred and the lender’s right to collect rents “returned,” rents could be used only to reduce the owner’s debt owed to the lender; (3) the assignment of rents terminated when the owner’s debt to the lender was satisfied. These three events reflected an assignment for security. The 6th Circuit BAP recognized that while isolated portions of the assignment may appear “absolute,” the context of the entire document indicates the assignment was intended as security.

The 6th Circuit BAP rejected the lender’s argument that because it took possession of the rents pre-petition, the rents could not be property of the bankruptcy estate. The lender sent notice to tenants to remit rent directly to the lender rather than the owner. Because the assignment of rents was deemed a security document, mere possession of the rents, even pre-petition, did not change the absolute ownership of the rents post-petition. The owner had a remaining property interest in the rents subject to the lender’s lien.

The 6th Circuit BAP ruled in favor of the lender, however, on whether the lender was adequately protected by the owner’s use of rents as cash collateral via a replacement lien. The owner did not hold any unencumbered assets to offer the lender adequate protection. The 6th Circuit BAP recognized that the lender has two distinct security interests, namely the mortgage on the property and a perfected security interest in rents, and each interest must be adequately protected. The Court rejected the assertion that the owner could use future rents to replace the expenditure of prior months’ rents for cash collateral purposes. Payment of cash collateral for professional fees is not adequately protected by a replacement lien consisting of future rents.

The lender’s efforts to bridge the “hopson choice” on treatment of rents and include both ownership and security language resulted in treatment of rents solely as security. At least in this federal circuit, which includes Kentucky, Tennessee, Ohio and Michigan, the debtor must demonstrate other collateral sufficient to adequately protect the lender while using rents for operations.